Valuers continue to seek to reflect market sentiment in the face of transactional inactivity. But how realistic is it provide a snapshot of a property's value when, effectively, there is no market? Richard Lowe investigates

The majority of real estate fund investors do not believe the valuations reported in the vehicles reflect fair value. This worrying statistic (65% of investors, 75% of fund of funds managers) was uncovered by the European Association for Investors in Non-listed Real Estate Vehicles (INREV) when it surveyed its members and illustrates the high level of uncertainty surrounding property valuations in the current climate.

"It is an issue for all the industry, fund managers and the investors," says Andrea Carpenter, research director at INREV. "They are all trying to understand how their funds have performed and that is very difficult when they know it is difficult [to obtain] solid underlying information about the value of the assets."

Carpenter is quick to point out that the situation is by no means a reflection on the valuation industry. "They are doing what they can in a difficult situation," she says. "When there are no transactions it is difficult to have comparative data and to understand where the market actually is."

It is doubtful whether real estate valuers have faced a more challenging environment than they do today. Twelve months ago, IPE Real Estate explored how valuers were attempting to reflect market sentiment in the face of dwindling transaction data due to the credit crunch. Since then the situation has not improved, but arguably has worsened.

The level of uncertainty was highlighted when International Property Databank (IPD) included an announcement with the October results for its UK monthly index, revealing that approximately 82% of the valuations underpinning its data came with warnings about market instability.

Such warnings are allowed by the Royal Institution of Chartered Surveyors' (RICS) Valuation Standards. Guidance Note 5 of the standards, which details the measures valuers should follow at a time of "valuation uncertainty", states: "Unforeseen macroeconomic or political crises can have a sudden and dramatic effect on markets. This could manifest itself by either panic buying or selling, or simply disinclination to trade until it is clear how prices in the market will be affected in the longer term. If the valuation date coincides with the immediate aftermath of such an event, the data on which any valuation is based may be confused, incomplete or inconsistent, with an inevitable effect on the certainty that can be attached to it."

Two weeks later, RICS issued further guidance on valuation uncertainty, encouraging valuers not to use Guidance Note 5 in such a way that could cause "the client or auditor to question the validity of the valuation, or to quality a valuation report".

Valuers in the UK have had an unenviable task over the past 18 months. It was clear that the UK was due a correction before the onset of the credit crunch in the summer of 2007. Despite a lack of comparables to turn to, it became apparent that prices had to be written down to reflect market sentiment. RICS was a vocal proponent of this approach. However, the speed with which the UK values dropped took everybody by surprise.

"What valuers have done on this occasion is unusual compared with the past," says Malcolm Naish, head of property at Scottish Widows Investment Partnership. "In the past, valuers have tended to move values more slowly, both on the way up and on the way down, because they have wanted to have the evidence to support the yields and the rents that they would be applying to arrive at their conclusion as to value.

This time round, a number of them saw quite early on that the price that someone was prepared to pay for a building was falling. Although the transactions weren't there to support the valuations, that to a degree was because the appraisal of those buildings wasn't meeting the needs and the expectations of the purchaser. Valuers quickly woke up to the fact that they were not doing their job properly if they didn't attempt to reflect that movement in value as accurately as they could."

Ian Cullen, co-founder and director of IPD, paints a similar picture. "In the context of thin evidence, they have used what they can and have been quite comfortable with the idea of marking down, even if there is not [another building] around the corner of exactly the same use and type," he says. "They have worked with what there is and reflected the overall sentiment in the market."

But should valuers be writing down assets without justifiable evidence? If it is argued that they shouldn't, the only alternative is to look back to the most recent period when there was a significant volume of transactions, but this is likely to give an outmoded perspective.

"A very mechanical way of applying the method would be to say, unless there is something precisely comparable with the asset I am trying to value, I will just hold values constant," says Cullen. "I suppose that is not terrible if the market is hardly moving at all and there is lots of evidence around which is suggesting it is hardly moving at all... But clearly when the evidence is around and is suggesting a radical re-pricing that policy is just not sustainable."

Of course, rather than being criticised for being too bold, valuers have more often been rebuked for not writing down values enough - that is, to a level at which investors would be willing to move back into the market.Paul Wolfenden, global head of valuation at DTZ, sees this view as untenable and one that ignores the central role the debt markets play in market activity. "I don't adhere to the sentiment that it is the valuers who are responsible for the lack of liquidity," he says. "If somebody wants to sell they will sell."

A number of UK-based asset managers see the way UK valuers have responded over the past 18 months to the lack of transaction evidence and deteriorating investor sentiment as undeniably positive. They also believe the "UK example" should be exported to continental Europe. Noel Manns, principal at opportunity fund manager Europa Capital, made this very point at INREV's conference for chief financial and operating officers in Lisbon in October.

Naish also believes the way UK valuers have responded is positive. "It has helped what little transactions there have been to be supported to a degree by valuers," he says. "Over time, people will come to look back at this period and feel that valuations in the UK have more credibility as a result of the valuers having moved the figures in response to what they could see were rapidly changing market circumstances."

William Hill, chief executive officer at Schroder Property, shares this view. "The last we all want in the industry is three years of a death of a thousand cuts," he says. "It is much better to face up to the new conditions, mark portfolios down, accept that and move on. If you look in other markets, particularly on the continent... the psyche over there is very different."

IPD data show that Ireland has experienced its own severe repricing in recent months, while the Spanish market is expected to show a significant correction when its annual figures are revealed. However, other markets in Europe are yet to match the re-pricing and yield shift in the UK. Why is the Continent lagging the UK and does this suggest that the UK is facing up to its problems, while the Continent, to some extent, is burying its head in the sand?

This is, admittedly, a simplistic view, but Naish does believe the UK market is the most developed in the world and that volatility in a market, while not always a welcome feature, is often the sign of a healthy underlying valuation system."Although I wouldn't go out of my way to have more volatility in a marketplace, if that volatility is deserved because of changing circumstances, then it is right and proper that valuers should reflect it," he says.

But it should also be noted that the absence of volatility in a market is not necessarily a sign of valuers failing to reflect the market. Cullen agrees that UK valuers are doing well to keep pace with the market volatility in the UK, but he warns against presuming that every market should be suffering the same level of volatility.

"Clearly, both the UK and Irish markets have benefited - or suffered, depending on your point of view - from a period of sustained and very significant growth, which has not been shared evenly," he says. "Most of mainland Europe has witnessed slower rates of growth in the early years of the decade and therefore the correction may be less sharp. But the valuation may also be slightly less sharp. It is difficult at this stage to tell."

Philip Parnell, partner at Drivers Jonas, believes UK valuers benefit from a "very transparent market" where parties involved in transactions are "generally willing to talk". He says: "It gives valuers a lot of information. I am not convinced, in fairness to our European counterparts, they are in such a privileged position."A fairly unique feature of the valuation industry in the UK is that valuers work much more closely with real estate brokers than is the case in many other markets, including those on the Continent and in the US.

"In the UK, valuers and agents tend to operate very close to one another," says Wolfenden. "On the Continent, valuers tend to be self-contained organisations... you don't have the interaction on the Continent between the valuers and the brokers."

There is evidence to suggest that UK valuers are more accurate than their French, German and Dutch counterparts: the latest joint IPD/RICS Valuation and Sale Price study, which compares prices achieved at the point of sale with preceding open market valuations, ranked UK valuers the clear winners. However, the valuation accuracy in the other markets covered was not drastically lower."They are basically fairly synchronised, at least on capital value judgments," Cullen says.

Market snapshot v sustainable value

Wolfenden expects the rest of Europe to follow the UK in its repricing and yield shift, not just because it is following the UK into an economic downturn, but because the globalisation of real estate investment means that markets are competing directly with each other for investor capital.

"The reason you are going to get yields in many other markets moving out and values coming down is that over the last 10 years the investment market has become much more of a global capital market and capital will flow effectively to the most common denominator," Wolfenden says. "So capital will look at yields in London versus yields in Frankfurt and they will say: why should I buy a prime building in Frankfurt at 5.25% when I could get a prime building in the City of London at 6.5%?"

Regardless of whether ultimately the investment case for one market is better than the other, global investors are likely to be attracted by yield levels in themselves. "The money will go to London as opposed to Frankfurt so inevitably yields will move out in Frankfurt," he says.

Germany is an interesting case. The real estate markets there have not experienced the same boom in prices as the UK and rents are starting at a much lower base.
Despite recent difficulties experienced by Hypo Real Estate and a number of state-owned banks, Henry Robinson, European partner at Drivas Jonas in Germany, believes sentiment in the country is "perhaps that things won't be as bad as they are being cited as being in the UK."

The volume of property transactions in Germany in 2008 (€20bn) is expected to be around a quarter of transaction volumes in 2007. However, this would not have looked out of place during 1993-2003, Robinson says. The recent upsurge has been driven by the influx of foreign investors, who have largely left the scene."There is perhaps a feeling that in that respect the property investment market is returning to where it had been traditionally," he says.

The German market is also known for its lack of volatility. The IPD index appears somewhat flat compared with the figures for other markets in Europe. This is partly because of the use of a German valuation methodology that seeks to arrive at a "sustainable" value and smooths out short-term market fluctuations. The method places much more emphasis on the income of a property, meaning that capital appreciation (or depreciation) is only realised when it is actually sold.

The approach is fundamentally different to the one that has led to the fast repricing in the UK. Whereas in the UK the role of the valuation is to reflect current market price - that is, provide a snapshot of the price the property could be sold at today - with all the volatility that comes with it, the German method makes a differentiation between "market price" and "sustainable value".

"Valuations in the UK are very market-driven," says Annette Barthelmes, director of asset management and chartered surveyor, at Invesco Real Estate in Germany. "It is always the market value, and definitions of value there are slightly different, because here it is about the earnings you can achieve and it is more of a sustainable value."
Both methods exist side by side in Germany, says Robinson. German banks are required by law to use the German method, while the growing numbers of international investors in Germany, which rely on international valuation companies, have increased the presence of the RICS Red Book method.

International valuers often claim that "sustainable value" is an illusory concept, while proponents of the sustainable approach argue that providing a snapshot of the market is misleading and reveals nothing about what values might be in the future.

The difference in perspective of these two approaches highlights a number of questions about real estate valuations. Is it realistic to mark to market illiquid assets when there is effectively no market? For example, if a building cannot be sold in the current market should its value be zero? Conversely, if real estate valuations always reflect a long-term value and smooth out market fluctuations, how can investors know what is happening in markets and make informed cross-border investment decisions?What is certain is that the debate between valuation methodologies looks set to endure indefinitely. "It is a never-ending story," says Barthelmes.